By Adam K. Wright, CFA®, CFP®
Retirement planning is far from simple, especially when you consider all the savings options available. Do you prioritize a 401(k) or a Roth IRA or an investment account? Each will present its own pros, cons, and unique opportunities for growth. While you know you need to invest, it can be challenging to decide between the account types and investment plans for your unique retirement.
Enter the Roth IRA. Let’s discuss why you should consider adding a Roth to your retirement plan, and ways to capitalize on all the benefits a Roth IRA offers.
What Is a Roth IRA?
Roth IRAs are retirement accounts with contribution limits, where the money is contributed after taxes, grows tax-deferred, and can be withdrawn tax-free when certain conditions are met. Using a Roth IRA effectively can result in significant tax savings over the long term.
It’s important to understand that a Roth IRA is not an investment itself but, rather, an account type. The Roth IRA is an after-tax retirement account named after its creator, William Victor Roth Jr. Within a Roth IRA, you can own various investments such as stocks, bonds, or mutual funds.
Despite the benefits, many people are not fully utilizing the potential of Roth IRAs for their retirements. To contribute to a Roth IRA, you need to have earned income, which typically includes wages from work or income from running your own business. Additionally, if only one spouse earns enough income, they can contribute to a Roth IRA on behalf of a non-working spouse. By taking advantage of a Roth IRA and with the help of a financial advisor, you can maximize your retirement savings and enjoy tax-free withdrawals in the future.
Rules of a Roth IRA
A Roth IRA is an IRA except for a handful of critical differences. There are important rules to keep in mind when it comes to opening a Roth IRA.
Firstly, there are income limits for contributions, which means that not everyone may be eligible to contribute to a Roth IRA based on their income level. Taxpayers cannot deduct contributions to a Roth IRA.
There also is the 5-year rule, which states that withdrawals from a Roth IRA may be subject to penalties and taxes unless certain conditions are met, such as reaching the age of 59½. However, it’s important to note that contributions made to a Roth IRA can be withdrawn at any time, for any reason, without incurring taxes or penalties. This flexibility allows you to save for retirement without worrying about your money being tied up if you need it for an emergency.
Retirement Tax Benefits
It can be tempting to think short-term and only utilize a traditional IRA for a current-year tax deduction, but Roth IRAs offer tax-free withdrawals in retirement (after the age of 59½), which could be an even greater benefit to you. A Roth is an incredible tool to help you limit and manage your tax liability in retirement.
Instead of being forced to pay income taxes on all the money you need to live on, you can decide how much to take from a taxable account and how to supplement it from a tax-free (Roth IRA) account in order to manage your tax brackets and minimize your tax burden. And unlike a traditional IRA, there are no distribution requirements from a Roth IRA. You can leave funds invested as long as you live, leaving them to grow tax-free.
A Roth IRA offers tax-free growth, meaning qualified withdrawals of earnings after the age of 59½, or those prior to that age but meeting a list of pre-approved circumstances, can be withdrawn with no tax consequences.
Remember that withdrawals of earnings prior to age 59½ or prior to the account being opened for 5 years (whichever is later) may result in a 10% IRS penalty tax. Talk to your financial advisor about the limitations and restrictions of a Roth IRA and whether it is right for you.
How to Start Using a Roth IRA
The good news is that there are several ways to make contributions to a Roth IRA. The first method is to contribute directly, which involves depositing funds into the Roth IRA account up to the annual contribution limit set by the IRS. This can be done either as a lump sum or through regular contributions over the course of the year. Check in each year as contribution limits do change over time.
Another option available is the backdoor Roth IRA strategy. This method is used by those who exceed the income limits for direct contributions to a Roth IRA. It allows you to make a non-deductible contribution to a traditional IRA and then convert that amount to a Roth IRA. This affords you the ability to take advantage of the tax benefits of a Roth IRA even if you are not eligible for direct contributions.
Finally, for those who have access to a 401(k) plan with an employer that allows after-tax contributions, the mega backdoor Roth IRA strategy can be utilized. The mega backdoor option involves making after-tax contributions to the 401(k) and then rolling over those contributions into a Roth IRA. This strategy allows for larger contributions to a Roth IRA beyond the regular annual contribution limits.
Still Have Roth IRA Questions?
Planning for retirement can feel overwhelming, especially when it comes to understanding different strategies. If you have questions about your retirement accounts and want to explore options like Roth IRA conversions or backdoor Roth IRA contributions, our team at Wright Associates is ready to assist. Contact us to schedule a complimentary phone call where we can review your situation and provide personalized guidance.
Adam Wright is a CERTIFIED FINANCIAL PLANNER™ professional at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.
Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.